Tax games: Are some companies playing with fire?

Some Canadian companies pay less tax by using byzantine structures that shuffle profits to lower tax jurisdictions around the world. While some have done this in what seems like a safe manner, others have come under investigation by CRA and the IRS.

For advisors, the challenge is to avoid those companies and structures. Otherwise, they could face large tax restatements and big hits to future profits and cash flows.

Case 1: Cameco Corporation

Uranium producer Cameco caught CRA’s eye back in 2008, and was reassessed for its taxes owing for 2003 to 2007. Since then, additional years have been re-examined, and CRA continues to look at more recent periods. All told, CRA may try to recover upward of $1.3 billion, before penalties, from Cameco.

At issue is the jurisdiction in which Cameco recognizes most of its profits. Although the firm mines its uranium in Canada, it says it sells a large portion of it through its subsidiary in Switzerland.

Read: Come clean with CRA

Back in 1999, Cameco set a transfer price agreement between its Canadian and Swiss divisions. At that time, the market price of uranium was around $10 per pound. It trended lower in subsequent years, but spiked higher starting in 2003, eventually topping $130 per pound. Under the original 17-year agreement, the Swiss subsidiary was paying $10 per pound to the Canadian division, and selling it into the market for huge profits.

CRA took issue with the conveniently priced long-term deal, which moved the profits to lower-tax Switzerland, and also the nature of the European operations. CRA alleges the actions conducted by the Canadian operations “constitute a sham” designed to deceive authorities to conclude that the Swiss subsidiary was undertaking a business and incurring the real risks. The tax authority further alleges the Swiss subsidiary didn’t have the financial or human resources to undertake its contractual obligations, and that all the work to sell the uranium was done in Canada (the whole issue is currently bogged down in the tax courts). And CRA adds the Canadian division performed the contract administration, inventory management and market analysis under a services agreement with the Swiss subsidiary, and directed any agreements with third parties.

Read: CRA has new tools to fight tax evasion

The share price of Cameco already reflects a significant discount, which is a combination of the tax issue and also a depressed uranium outlook worldwide. Our guess is that Cameco could be liable for 50% to 75% of the estimated taxes, should a settlement take place.

Case 2: Valeant Pharmaceuticals

Pharma giant Valeant has gained widespread attention this year for its tax inversion proposal with Allergan. But not as many advisors are aware of the recent investigation launched by the IRS into the company’s affairs. Valeant announced in August that “during the second quarter of 2014, the IRS commenced an audit of the Valeant U.S. consolidated group for its 2011 and 2012 tax years.” While it’s just one sentence buried in a 123-page regulatory filing, it could spell big trouble for the company, depending on the findings of the investigation.

The timeframe would suggest the IRS is focused on the low tax rates that Valeant has reported since it joined with Canadian-based Biovail in 2010. (Biovail actually acquired Valeant, but the new firm is called Valeant Pharmaceuticals International, Inc. It also has Canadian residency and tax status.)

Canada allows profits to be repatriated tax-free from lower-tax jurisdictions with which it has a tax treaty. In the pharma business, regardless of where the sales take place, profits can be recognized largely in the jurisdiction that holds the intellectual property for the drugs. Through the magic of transfer pricing agreements, the profits can be consumed by IP licensing fees.

Since the combination with Biovail, Valeant has managed to lower its cash tax rate to 3% in 2013, versus 36% in 2009.

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As with Cameco, the tax authorities are probably focused on whether substantial corporate operations (sales, licensing, legal and other services) are actually being carried out offshore. And if that’s the case, there is the question of how Valeant managed to transfer such seemingly valuable IP assets to other jurisdictions without incurring significant tax hits in the first place. Overall, this seems like the early stages of potential trouble for Valeant.

Case 3: Gildan Activewear

Gildan, a global leader in the branded apparel and printwear markets, has enjoyed low tax rates for more than 15 years due to Canadian tax treaties with lower-tax jurisdictions. The company’s subsidiary in Barbados was set up in 1999, and handles the company’s international sales and marketing duties for its printwear segment (the company’s classic blank t-shirts and sportswear).

In 2013, printwear sales represented two-thirds of consolidated revenue and over 80% of operating income. However, since Barbados’ tax rates are in the low single digits, Gildan was able to lower its 2013 statutory rate from 26.9% to just 3.2%.

It’s worth asking why Canada allows companies to repatriate profits tax-free from low-tax jurisdictions, simply because a treaty exists. After all, treaties are meant to eliminate double taxation, not eliminate taxes altogether. Is this something that could change and catch investors off guard? It seems like government policy on the matter is confused, to say the least.

Read: 8 ways to cut taxes in 2015

While the friendly arrangements enable Canada to crack down on tax-haven cheats and encourage international business expansion, it seems some large loopholes exist as an unintended consequence. For now, there’s no indication that anything will change in the short term, and Gildan investors can probably rest easy.

Substance counts

Companies that truly have offshore operations in low-tax jurisdictions are more likely to receive a clean pass from tax authorities.

While Gildan actually set up its sales and marketing office offshore, it’s unclear whether Cameco and Valeant did the same. So, when scouring investments for potential tax pitfalls, advisors should question any company in a mature state that has an effective tax rate substantially lower than its statutory rate.

At that point, an examination of the substance of the duties carried out offshore needs to be made. The last thing any advisor wants is for the authorities to label one of their investments a tax sham.

Read: Single or married? Why you can’t hide from CRA